INDIAN INSTITUTE OF MANAGEMENT JAMMU

Tentative Answers to the Practice Questions

Program: MBA (Batch 2020-22), Term II
(Academic Year 2020-21)

Course: Macroeconomics

Date: 21/November/2020

1. You live in a country called Motoria (M). Motoria produces only two products: Cars
and Motorcycles. The Output and Prices of these goods are shown in the following
table:

Output Price
Year Output (Cars) Price (Cars)
(Motorcycles) (Motorcycles)
2017 300 1000 70 200
2018 300 2000 80 500
2019 500 2500 100 550

a) Calculate the nominal GDP for all 3 years.

Nominal GDP mean the GDP at the prices which were prevailing during those
years
2017 300 x 1000 + 70 x 200 = 3,14,000
2018 300 x 2000 + 80 x 500 = 6,40,000
2019 500 x 2500 + 100 x 550 = 13,05,000

b) Compute the annual growth of the nominal GDP.

2017 to 2018 6,40,000 − 3,14,000
(( ) 100) = 103.8%
3,14,000
2018 to 2019 13,05,000 − 6,40,000
(( ) 100) = 103.9 %
6,40,000

c) Calculate the real GDP in 2018 and 2019 using the 2017 as the base year.
2017 300 x 1000 + 70 x 200 = 3,14,000
2018 300 x 1000 + 80 x 200 = 3,16,000
2019 500 x 1000 + 100 x 200 = 5,20,000

d) Compute the annual growth rate of real GDP.

2017 to 2018 3,16,000 − 3,14,000
(( ) 100) = .06%
3,14,000
 2018 to 2019 5,20,000 − 3,16,000
(( ) 100) = 64.5 %
6,40,000
(Hint: Classroom discussion Session 3, 4 & 5)
2. Consider an economy that consists of only those who bake breads and those who
produce its ingredients. Suppose that this economy’s production is as follows:
 1 million loaves of bread (sold at $2 each);
 1.2 million pounds of flour (sold at $1 per pound);
 100,000 pounds of yeast, sugar and salt (all sold at $1 per pound).
 The flour, yeast, sugar and salt are sold only to the bakers, who use them
exclusively for the purpose of making bread.
a) What is the value of output in this economy (nominal GDP)?
Since nominal GDP is defined as the market value of all final goods and services
currently produced in this country, we can only measure the value of the final
product (bread), and therefore we get $2 million (since 1 million loaves are
sold at $2 each).

b) How much value is added to the flour, yeast, sugar and salt when bakers turn
them into bread?
An alternative way of measuring GDP is to calculate all the value added at each
step of production. The total value of the ingredients used by the bakeries can
be calculated as:
1,200,000 pounds of flour ($1 per pound) = 1,200,000
100,000 pounds of yeast ($1 per pound) = 100,000
100,000 pounds of sugar ($1 per pound) = 100,000
100,000 pounds of salt ($1 per pound) = 100,000
_________________________________________________________
= 1,500,000
Since $2,000,000 worth of bread is sold, the total value added at the bakeries
is $500,000.
(Hint: Classroom discussion Session 3)

3. Assume that labor demand and supply curve of the competitive market of a country
is given by
𝑊𝐷 = 600 − 0.04𝑄
𝑊𝑆 = 80 + 0.01𝑄
a) Calculate the equilibrium wage and quantity and draw both curves in a diagram

𝑊𝐷 = 𝑊𝑆
 600 − 0.04𝑄 = 80 + 0.01𝑄
520 = 0.05𝑄
𝑄 = 10400
Equilibrium wage
𝑊𝐷 = 600 − 0.04𝑄
𝑊𝐷 = 600 − 0.04 ∗ 10400
𝑊𝐷 = 184
b) Suppose that agitation had taken place
by the labor unions were able to increase the wages and the employers had
agreed to increase the wages to 200 per day. How many people added to the
unemployed labor force when compared with the answer that you got in part (a)
200 = 600 − 0.04𝑄
400 = 0.04𝑄
𝑄 = 10000

400 new employed people will be added to the unemployed labor force

4. As per the discussion we had in the Solow model, the investment has emerged as a
key player for deciding about any particular level of output.
Assume the relationship between capital and output is Y = √K and one third of the
national output will be invested. Further assume that all the other factors (population
and technology) are constant but machinery is depreciating over time as 0.02𝐾 = 𝐷
a) At which capital stock is the investment just sufficient to reach a steady state?
At steady state, investment should be exactly equal to the depreciation of
existing capital. Therefore 𝐼 = 𝐷
1
√K = 0.02𝐾
3
√K = 0.06𝐾
√K
= 0.06
𝐾
1
= 0.06
√K
1
= √K
0.06
(16.66)2 = 𝐾
277.5 = 𝐾
b) Describe why the capital stock cannot be the driving force of economic
growth?
If the capital stock is quite small the depreciation will be small, too. Therefore,
investments will increase the capital stock until it reaches the point where D
is equal to I. If on the other hand the capital stock is too high, there will be more
 depreciation than investments. In this case the capital stock decreases.
Because of that the capital stock will be balanced at a “steady state” and
therefore there cannot be any growth of the output
Since technological progress enhances the productivity per working person.
So if the rate of employment remains constant, technological advances will
increase the GDP per head

5. In the foreign exchange market the Euro (€) is traded against the US dollars ($). View
the € as the home currency so that the exchange rate (in price notation) is 𝐸𝑅€$ , it
tells us how many € we have to pay to purchase $1.
The exchange rate ER0€$ (Base period) = 0.8 which has moved to ER1€$ (End Period) =
1.0 over a years’ time. Which currency appreciated, which one depreciated and how
large is the per cent change in either direction?
Since you have to pay more euros to buy one dollar the value of the US dollar has
appreciated whereas the euro has depreciated. The appreciation of the dollar is:
ER1€$ − ER0€$
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐴𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 $ = ∗ 100
ER0€$
1 − 0.8 0.2
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐴𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 $ = ∗ 100 = ∗ 100 = 25%
0.8 0.8
1 1
1 −
ER €$ ER0€$
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 € = ∗ 100
1
ER0€$
1
1 − 0.8
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 € = ∗ 100
1
0.8
0.2
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 € = 0.8 ∗ 100 = 20%
1
0.8

6. The text explained that purchasing power parity demands, that exchange rate is
determine ratio of purchasing powers that people in different countries have (ratio
𝑃ℎ
of prices in home in rupees (𝑃ℎ ) and foreign in Dollars (𝑃𝑓 )). 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒 = .
𝑃𝑓
a) Prices in the foreign economy are at Pf = $1.25 and the exchange rate is = 0.8.
What is the price level in the domestic economy?
𝑃ℎ = 1
b) Keep the exchange rate as 0.8. How high are prices in the foreign economy, if
the price level at home is at 𝑃ℎ = 1.80?
 𝑃𝑓 = $2.25
c) Assume the information given in part (a), what would you expect to happen
to the exchange rate if the price level in the home country were to increase by
20% (inflation rate =20%)?
1.20
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒 = = .96
2.25
Exchange rate has depreciated
. 96 − .80
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = ∗ 100 = 20%
. 80
d) Prices in the home country are at Ph = 1.50 and the price level abroad is Pf =
$2.40 and exchange rate is .80. Is the rupee overvalued or undervalued?
According to the purchasing power parity of exchange rates, the exchange rate
should theoretically be at 0.625. If in fact the exchange rate stands at 0.8[€$],
therefore, rupee is undervalued